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IAI Actuarial Core Principles · Business Economics · Supply-side policies and their impact on businesses

The government gives a Rs 200 crore grant to private firms for research and development. The firms' private marginal benefit from R&D is lower than the marginal benefit to society because knowledge spreads to other firms. What is the economic case for the grant?

The grant addresses under-investment caused by a positive externality. Because knowledge spills over to other firms, private returns from R&D fall below social returns, so firms invest too little. A subsidy narrows that gap and moves R&D nearer the socially optimal level, raising long-run productive capacity.

  1. AIt corrects under-investment caused by a positive externality, moving R&D closer to the socially optimal levelCorrect
  2. BIt removes the free-rider problem by making knowledge excludable
  3. CIt lowers firms' marginal tax rates and so raises work incentives
  4. DIt reduces unemployment by cutting the real wage
  5. It reduces the money supply and so lowers inflation

Explanation

Spillovers mean firms ignore part of the benefit of their R&D, so the market provides too little. A subsidy raises the private return towards the social return and increases R&D, which can raise productivity and long-run supply. The grant does not make knowledge excludable, nor does it cut taxes, wages or money supply.

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